ESG does neither very well nor very well

Trillions of dollars have flowed into environmental, social and government funds in recent years. In 2021 alone, the figure grew by $8 billion a day. Bloomberg Intelligence projects that more than a third of all global assets under management could carry explicit ESG labels by 2025, amounting to more than $50 trillion. But for a financial phenomenon so widespread, there is surprisingly little evidence of its tangible benefits.

The implicit promise of ESG investing is that you can do well and do well at the same time. Investors assume they can provide a market return while promoting causes such as lowering carbon emissions and income inequality. But several studies show that ESG strategies do not do much of either. Bradford Cornell of the University of California, Los Angeles and Aswath Damodaran of New York University reviewed shareholder value created by companies with high and low ESG ratings – scores provided by professional rating agencies. Their conclusion: “Telling companies that being socially responsible will lead to higher growth, profits and value is false advertising.”

What Messrs. Cornell and Damodaran found on a micro level is also evident on a macro basis. Over the past five years, global ESG funds have underperformed the broader market by more than 250 basis points per year, returning an average of 6.3% compared to a return of 8.9%. This means that an investor who put $10,000 into an average global ESG fund in 2017 would have about $13,500 today, compared to the $15,250 he would have made if he had invested in the broader market.

Did the forgotten $1,750 somehow do good for humanity for $1,750? Apparently not. A new report by researchers at the universities of Utah, Miami and Hong Kong finds that there is “no evidence that socially responsible investment funds improve corporate behavior.” But that shouldn’t come as a surprise. The same result followed decades of investors avoiding so-called sin stocks – alcohol, tobacco, firearms and gambling. In doing so, investors sacrificed returns while the behavior they disapproved of continued. Impact investors want their capital decisions to create results that would not otherwise have existed, not maintain the status quo.

ESG and anti-sin investing have failed for the same reason: divestment is an ineffective tool for generating excess returns and changing societal outcomes. It does the exact opposite of what it intends. Divestments raise returns for those shareholders who remain invested and remove shareholders who are likely to fight for corporate reforms. As a broad thesis, it is best to assume that products and services that can be provided legally and profitably will be, no matter how much others reject them. This includes fossil fuels. The production of goods and services declines when people stop buying them – not when others stop investing in the companies that produce them.

So what needs to change about ESG investing? To start with, all ESG funds should provide impact reports with their financial returns. These reports should highlight the specific “additionality” of the funds, detailing the benefits they created that would not have otherwise occurred. Such impact funds and reports exist – particularly in fixed income – but are a very small part of the overall ESG public equity market.

More basic makeovers are needed. Composite ESG scores – which attempt to summarize all material ESG risks into a single number or grade – provide little actionable investment information. “I have not seen circumstances where combining an analysis of E, S and G together across a wide range of companies with a single rating or score would facilitate meaningful investment analysis that was not materially overly broad and imprecise, ” the Securities and Exchange previously said. Commission Chairman Jay Clayton during an SEC hearing in March 2020. An example: Tesla‘s

two leading rating agencies’ current ESG scores are lower than Pepsi’s. Does this mean that electric vehicles are worse for the planet than soft drinks, or that socially concerned investors should overweight Pepsi and underweight Tesla in their portfolios?

No investment strategy, ESG or otherwise, can be better than the data it is based on. This is especially true for the “S” in ESG. Social customs are constantly changing.

Comparing credit and ESG ratings illustrates how much work lies ahead for ESG analysis. Widely accepted financial accounting practices have allowed competing rating agencies such as Fitch, S&P and Moody’s to reach similar credit ratings 99% of the time. The same cannot be said for their ESG counterparts, such as MSCI and Sustainalytics. In a recent paper, researchers Florian Berg, Julian Kolbel and Roberto Rigobon found that ESG scores among leading rating agencies correlated only 54% of the time – or barely one in two. ESG ratings are all over the map because the underlying assumptions, methodologies and data inputs vary widely among ESG rating agents.

Another area of ​​ESG ripe for reform: disclaimers. At the end of long ads for popular sustainable investment funds, you will often find something like the following: “There is no guarantee that any fund will exhibit positive or favorable sustainability characteristics.” We pay more for organic food precisely because we believe it has desirable, verified properties. If sustainable investment funds cannot be expected to exhibit favorable sustainability characteristics, they should be called something else.

ESG is derided from the left for being too timid and from the right for being too aggressive. The harder truth is that ESG largely fails on its own terms. Despite tens of trillions in ESG investments, investors have not done very well or generated much good. ESG advocates need to do better or stop claiming they can.

Mr. Keeley is the Chief Investment Officer at 1PointSix LLC and the author of “Sustainable: Moving Beyond ESG to Impact Investing.” He was a senior manager at BlackRock, 2011-22.

Journal Editorial Report: How many other states will sign on to an electric-only future? Images: AFP via Getty Images Compiled: Mark Kelly

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